Should the Fed raise interest rates?

The Federal Reserve has been dragooned into all sorts of extraordinary extracurricular activities in the past year (buying up long-dated Treasurys, anyone?), so it's easy to forget that the central bank has only two mandates: maintain stable prices and promote maximum employment.

Too bad those goals are very much at odds these days. Keep rates low, and the Fed just might put folks back to work sooner rather than later, fulfilling its mandate on the jobs front. But keep rates too low for too long, and the Fed risks sparking inflation, thus failing in its mandate for stable prices.
What, oh what, is a responsible central banker to do?

Step very, very carefully, experts say. "The Fed is walking a tightrope between stimulating the economy and maintaining a stable currency," says Curt Lyman, managing director at HighTower Advisors in Chicago. "Fed policy is intertwined between helping banks repair their balance sheets and putting people back to work as quickly as possible."

It's a dangerous, difficult path. Both the Fed and Treasury are "walking a razor's edge," Lyman says. They've got to strike an optimal balance among a host of competing demands, including increasing the federal deficit, adding stimulus to the U.S. economy, growing U.S. share of exports versus imports without scuttling the economies of our trading partners, all while repairing our financial system and putting our citizens back to work.

Whew. And as much as the Fed's mandate focuses on jobs and prices, the first order of business seems to be helping the banks. Low interest rates make borrowing cheaper for financial institutions, thus helping them fix balance sheets bruised and battered by hard-to-value toxic assets. That's a key goal, because banks need to have incentives to lend in order to keep the credit markets churning.

Unfortunately, as we noted recently, as long as the Fed continues to print money through a zero-interest-rate policy and so-called quantitative easing, the U.S. continues to run a big trade deficit, and other nations move their foreign exchange reserves out of dollars, the buck has no place to go but down. And that's got plenty of folks worrying about inflation, not to mention the future role of the dollar as the world's reserve currency.

After all, the U.S. Dollar Index, which measures the greenback against a basket of major currencies (you can see the related ETF here UUP), is off 3 percent in the last year and a whopping 15 percent since early March. Stocks, meanwhile, owe part of their remarkable rally since the spring low to the declining dollar. So the buck is burning -- and that's great news for stocks, at least for now. That's because 50 percent of the S&P 500's revenues and 40 percent of its earnings come from foreign sources -- so a weak dollar bodes well for both top- and bottom-line corporate performance.

But if the dollar is crashing in the short term, does that mean whiplash inflation is inevitable? Not really, says Carl Steidtmann, chief economist and director of Deloitte Research in New York. Just because the dollar is off against other major currencies doesn't mean consumer prices will go up here at home. After all, consumers need to spend their incomes in order to create upward price pressure.

"If anything, we are in a deflationary environment," Steidtmann says. "If you look at the consumer price index year-over-year, prices are down when you remove the shelter [housing and rents] component."

Make no mistake: Deflation is more fearful than inflation because consumers defer purchases in anticipation of lower prices later, creating a vicious cycle where corporate margins and profits get squeezed, squeezed, squeezed. Deflation is also tougher to combat at the policy level because the Fed can't cut rates below zero.

Besides, a crashing dollar among currency traders is hardly the same thing as inflation, says Mickey Cargile, managing partner at WNB Private Client Services in Midland, Texas. "The falling dollar in and of itself does not create measurable inflation," Cargile says. "Wage inflation is the cause of measurable inflation, and I doubt that workers have any ability to demand higher wages with high unemployment."

It's easy to see why Cargile takes that stand: Economists, on average, forecast unemployment to hit 10 percent by the end of the year -- and tick down to just 9.3 percent by the end of 2010. Inflation, meanwhile, is expected to stay well below 3 percent until the end of next year, at least.

If those forecasts are indeed correct, then the Fed would do well to keep rates as low as possible for as long as possible. It's hard to see how inflation could rear its ugly head with so many people out of work -- or at risk of losing their jobs.